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Our ‘Brave New World’

04/11/2014

Martin Conlon

Head of Australian Equities

Instances on which we have agreed with Rupert Murdoch have tended to be ephemeral at best, however, comments he made when addressing G20 finance ministers recently marked one of these. He commented that the “ladder of generational progress” was now at risk in the developed world and that a moment of “great global reckoning” had arrived. He noted that quantitative easing had increased the price of assets such as stocks and real estate, helping first and foremost those who already have assets. Meanwhile, the lack of any real wage increase for middle income workers means growing societal divisions and resentment. As the attendees at Joe Hockey’s taxpayer funded dinner were plied with the finest Australian food and wine, I suspect that the second glass of pinot didn’t cause them to rue the mistakes of recent decades and vow to address Mr Murdoch’s moment of great global reckoning.

The reality of their actions remains starkly reflected in stock market structure. In Australia, the financial sector dominates market capitalisation to the greatest degree ever. October saw these extremes pushed sharply higher as everything financial and yield rallied and everything ‘real’ didn’t. Standing against this increasingly powerful momentum is proving painful for our investors, and for this we apologise. Domestically, the erosion of manufacturing and the return of normality for commodity prices have left Australian asset prices resting on pillars of sand. Commodities represent more than half of total exports and have been responsible for almost all of the income gains of Australia relative to the global economy. Resource stock pricing is reflecting a much bleaker future, yet no-one seems even slightly concerned at the broader economic implications. The need for income to support asset valuations has been debauched by an expectation that policymakers will resist and quell any incipient asset price declines. Much faith rests on the belief in the omnipotence of central bankers. Few are questioning the sustainability of a system which spreads resources increasingly unfairly. Every disappointing ‘growth’ reading is met by further monetary accommodation and platitudes such as ‘doing whatever it takes’. In this ‘Brave New World’, we have been conditioned to respond positively to such dogma. Witness the 4% rally in Japanese equities on the last day of October in response to promises of further monetary expansion. Perpetually rising debt levels in Japan, now at more than 600% of GDP for the private and public sector combined, and no discernible change in economic trajectory appear no barrier to an expectation of a new and better outcome this time. As Huxley noted in the abovementioned novel, “One believes things because one has been conditioned to believe them”. “If one’s different, one’s bound to be lonely”.

Much as we may wish for an environment which does not wildly distort resource allocation in an economy, we must deal with the one that faces us. The upcoming Medibank Private float provides the next challenge in this regard. Free market forces are almost totally absent, with regulatory structures and government policy dominating the destiny of investors. The term health insurance is probably the first misnomer, as health insurance industry participants take no insurance risk, leaving the primary role of the business as collecting premiums and paying claims. In reality, the industry is largely a tax, primarily levied on the young to pay for the elderly. The industry collects nearly $20bn of premium, pays $17bn in claims and reports profits of more than $1bn after expenses of slightly less than $2bn. Incentives to promote a more cost effective and efficient system are almost totally absent, as cost increases are passed on to a largely involuntary member base as higher premiums. Unsurprisingly, everyone involved in the system, including private hospitals, believes things are operating swimmingly. Much as an ungeared return on equity of north of 20% for a player demonstrating almost no scale benefits or signs of operating efficiency seems egregious, not to mention the chance to pay more than 20 times earnings for this already high return, the industry structure could perversely be one of Medibank Private’s greatest assets. The greatest potential positive, at least from our perspective, is not the ability to cut costs, but the potential to play a role in more efficient healthcare provision. As governments everywhere struggle with ballooning healthcare costs, keeping the claims level under control and allowing the government to shift more of its expenditure into the private sector is likely to become increasingly important. This (theoretical) potential aside, there is little doubt that the government will achieve a more than fair price for the sale despite having provided no visibility on the future path of regulation. However, with the apparent tailwinds of regulation, ageing demographics and forced price increases, we expect most investors will not delve much deeper. Nothing like a bit of GDP plus growth to ensure the dominant investment strategy is that of the three wise monkeys!

On the subject of regulation, the start of bank reporting season served to highlight that APRA continues to fulfil their role as investors’ greatest allies when it comes to supporting the returns of the financial sector. Still reeling from the aftermath of the collapse of HIH in 2001 (which created few ructions in the marketplace whatsoever), excessive prices to consumers and massive barriers to new entrants in banking and insurance, are in their eyes, small prices to pay for the purported security of the financial system. Existing players are again the greatest supporters of the regulator, as the status quo is suiting them nicely. Operating profits for the big four banks have swelled from around $22bn in 2006 to $45bn in 2014, a growth rate which dwarfs that of most other sectors. When it comes to borrowing against housing, we remain global leaders. In combination with benign bad debt experience (a trend which usually accompanies buoyant asset prices rather than fundamental economic strength), this is the secret sauce behind the inexorable rise of financial stocks in the domestic stock market. NAB, ANZ, CBA and Westpac shared the love relatively evenly in October, a trait we find increasingly common and increasingly worrying in terms of overall market activity. With NAB still lagging the market capitalisation of CBA by nearly $50bn despite a similar asset base, it is here that we believe the greatest opportunity lies. A largely revitalised management team under Andrew Thorburn has engendered us with a greater degree of optimism in the likelihood of success than has been the case for some time, however, bitter experience will serve to temper this until tangible gains are evidenced. We sincerely hope that Yogi Berra will not be right in this being “Deja vu all over again”.

As alluded to above, lemming behaviour in terms of sector trends was all too apparent in October. A potential bid for Transfield Services by Ferrovial saw Leighton, UGL, Lend Lease and Downer EDI rise in sympathy. Gaming was eerily similar, with Tabcorp, Tatts Group, Aristocrat Leisure and Echo Entertainment. Resource names remained as popular as a fox in a hen house, with most savaged.

Outlook

As we have noted on countless previous occasions, and Rupert Murdoch has eloquently highlighted, central bank policies aimed at banishing the evil spectre of deflation are having increasingly powerful side effects. The logical outworking of their manic belief in prices only ever being allowed to rise is that the quantity of money and credit in circulation must grow in perpetuity. As this vision all but ensures that wealth is constantly transferred to those already controlling the assets and ensures instability in asset prices as the income supporting them (the real economy) declines relative to these prices (i.e. income yields collapse on all assets), we tend to concur with Mr Murdoch in believing a moment of great global reckoning is at hand. Whilst trying not to let these views stymy our attempts at building a sensibly diversified portfolio, our reluctance to embrace current yield and asset price levels as a baseline for sustainable earnings, and the increasing dominance of asset price derivatives (banks, REIT’s, insurers, fund managers, infrastructure, utilities) makes these efforts increasingly problematic.

My learned colleague Mr Fleming, remarked recently that things have an eerie similarity to 1989. Fundamentals are eroding quickly, the Chinese have replaced the Japanese as the buyers of golf courses and luxury property and gambling and property development are experiencing renewed buoyancy. These trends would not normally be harbingers of good times to come.

We feel sure that the time to be more cognisant of protecting capital versus trying to grow it aggressively is now. The ways in which we are seeking to do this bear little resemblance to previous experience as it has been traditionally defensive businesses and assets that have been most aggressively re-priced in the search for yield. However, with the yield of many energy and resource names now approaching those of the defensive favourites despite payout ratios which are markedly lower, we feel that safety is more likely to be in unexpected avenues.

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Investment strategy of recent years has been somewhat monotonous. Martin Conlon, Head of Australian Equities, discusses one the most frequent asked questions we face is: What is the catalyst for these trends to change?

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